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'Irrational exuberance' -- again
Remember the stock bubble? Yale economist Robert Shiller, says we're just as mad for real estate.
January 25, 2005: 12:54 PM EST
By Robert J. Shiller

NEW YORK (MONEY Magazine) - Yale University economist Robert Shiller made one of the great calls in stock market history. His book "Irrational Exuberance" hit the shelves in March 2000, the same month the tech-stock bubble struck a sharp pin.

Timing helped turn "Irrational Exuberance" into a bestseller, but Shiller had been predicting for several years that excessive speculation would prove a disaster for many investors.

A few days before Alan Greenspan famously used the phrase "irrational exuberance" in a December 1996 speech, Shiller had been at lunch with the Fed chairman, arguing that the stock market was irrational and suggesting that Greenspan might have something to say about how overvalued it had become.

Shiller's first tome focused exclusively on the stock market. A substantially revised edition of "Irrational Exuberance", to be published in April, includes a new chapter on what Shiller believes is the bubble in residential real estate.

The housing-price boom that is taking place in big metropolitan areas in the United States and around the world, he maintains, has no basis in economic fundamentals or precedent in real estate history.

Even if you don't buy Shiller's argument, you'll want to know what he's thinking -- and not just because he was right once. Shiller knows this subject. He and Wellesley College professor Karl Case are principals in Fiserv CSW, a respected real estate analysis and forecasting firm.

Below is a MONEY exclusive: excerpts from the new edition of Irrational Exuberance, in which Shiller aims to pop the conventional wisdom about the causes and sustainability of the current boom, and about the real return of investing in homes.

There are always popular explanations for real estate booms, but "popular" doesn't mean "correct."

A number of glib rationales have been offered for the run-up in prices in many places in the United States and elsewhere since the late 1990s. One is that population pressures have built up to the point that we have run out of land and that home prices have shot up as a result. But we didn't just run out of land since the late 1990s: Population growth has been steady and gradual.

Another theory is that the things that go into houses -- the labor, the lumber, the concrete, the steel -- are in such heavy demand that they have become very expensive. But construction costs are not out of line with long-term trends.

Finally, some argue that the boom is due to the interest-rate cuts implemented in many countries in an effort to deal with a weak global economy. But while low interest rates are certainly a contributing factor to rising home prices, central banks have cut interest rates many times in history, and such actions have never produced such concerted booms.

There is no hope of explaining home prices solely in terms of population, building costs or interest rates. None of these can explain the "rocket taking off" effect starting around 1998.

So what did cause this real estate boom in so many parts of the world? My conclusion: Home-price speculation is more entrenched on a national or international scale now than ever before.

In the United States before 1960, people were living in a less avowedly capitalist economy, and they were not primed to believe that their well-being depended in large measure on their property.

Today, with good public information about prices -- information that might help generate irrational exuberance -- widely available, our increasing public commitment to market solutions to economic problems has led people to worry more about home prices, and hence to make them more prone to the kind of feedback that generates bubbles.

Stories have abounded since 2000 of aggressive, even desperate, bidding on homes. People have been afraid that the price of housing would soon rise beyond their means and that they might never be able to afford a house, and so they have rushed in to bid.

Regional housing booms aren't uncommon, but what's going on today is different -- and dangerous.

It is commonly said that there is no national home market in the United States, only regional markets. There is something to that statement, but it is not completely true, and it appears to be getting less true. Real (that is, inflation-adjusted) home prices for the U. S. as a whole increased 52 percent between 1997 and 2004.

Yes, the increase was higher in some areas and lower in others, but the fact that there was a 52 percent increase overall is remarkable. There was only one similar time in U.S. history: the period that followed World War II.

The ascent in home prices since 1998 has been much faster than the rise in incomes, and this raises concerns about the long-run stability of home values. From 1985 to 2002, the median price of a home rose from 4.9 years of per capita income to 7.7 years in the eight most volatile U.S. states; thus in these states, which account for more than a quarter of the country's population, there are significant new stresses on family budgets in making mortgage payments.

This price behavior is dramatically different from the behavior of long ago. The late 19th and early 20th centuries saw many local bubbles surrounding the building of highways, canals and railroads.

Even when land was so abundant that one could buy it, in some places, for a dollar an acre, there could be real estate booms. If land prices were to go up to $2 an acre near a new rail line, this prospect could be quite exciting to investors. Regional real estate booms are nothing new.

But there was no national boom in home prices to accompany the sharply rising stock market of the Roaring Twenties. Home prices were not carried along by the stock market, nor did they drop in real terms when the stock market crashed starting in 1929.

After World War II, there were large real home-price increases, at least in the big cities. Government restrictions had severely limited the supply of new homes during the war. Returning soldiers wanted to start families; they were about to launch the baby boom.

But prices in that period did not overshoot, and they did not have to come crashing back down. Even though demand soared, there was no real buying panic, as the conventional wisdom of the time was that construction would soon greatly increase the stock of available homes.

It is different now. We are feeling worried and vulnerable, and the market volatility that flares up from time to time, in both the stock market and the housing market, reflects this.

The big glamour cities (and associated regions) of the world can experience a massive boom at the same time. The similarity among the price paths for these cities (really stunning price increases both in the late 1980s and after the late 1990s, with stagnant or falling prices in between) is striking, as is the similarity of popular stories of exaggerated excitement about and speculation in homes. Whatever it is that drives this excitement, it can cross vast oceans.

The notion that home prices always go up is very strong, and very wrong.

It is true that, for the United States as a whole, real home prices were 66 percent higher in 2004 than in 1890, according to the index my research assistants and I have put together. But all of that increase occurred in two brief periods: the time right after World War II and since 1998.

Other than those two periods, real home prices overall have been mostly flat or declining. Moreover, the overall increase, including the booms, is not very impressive -- 0.4 percent a year.

Why then do so many people have the impression that home prices have done so well? People remember the prior purchase price of a home from long ago and are surprised at the difference between then and now. In closing out the estate of an elderly person, one may be surprised to see that he purchased a house in 1948 for $16,000 and that the estate sold the house in 2004 for $190,000.

The appearance is that the investment in the house did extremely well. But the consumer price index rose eightfold between 1948 and 2004, so the real increase in value was only 48 percent, or less than 1 percent a year.

In fact, the theoretical argument that home prices can be expected to appreciate faster than consumer prices in general isn't strong. Technological progress in the construction industry may proceed faster than in other sectors. Barbers and teachers and lawyers are doing things more or less as they always have, but new materials, new equipment and prefabrication help make housing cheaper.

As for land prices, in most parts of the United States there is abundant land relative to demand. There is still plenty of room to spread out. True, there is little empty land available to build on in Los Angeles or Boston, or, for that matter, in London or Sydney.

But when home prices rise to the point that mortgage payments take up a large share of family income, there is a powerful incentive to move to a lower-cost area. This safety valve tends, in the long term, to prevent the price of homes from rising too much and to burst bubbles that have inflated too far.

The increase in home prices since 1980 in Los Angeles has really not been so much larger than in Milwaukee. But Los Angeles has gone through two booms and a crash along the way.

Life was simpler once; one saved, bought a home as part of normal living and didn't think to worry about what would happen to its price. The increasingly large role of speculative markets for homes, as well as of other markets, has fundamentally changed our lives.

The price activity that was once very localized and connected to the building of highways and the like is now connected to popular stories of new economic eras. The changing behavior of home prices is a sign of changing public impressions of the value of property and of a heightened attention to speculative price movements. It is a sign of a bubble, and bubbles carry within them the causes of their ultimate destruction.  Top of page

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