Russ Roberts

Shiller on Housing and Bubbles

EconTalk Episode with Robert Shiller
Hosted by Russ Roberts
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Robert Shiller of Yale University talks with EconTalk host Russ Roberts about the current housing mess and related financial market problems. Shiller argues that the decade-long run up in housing prices was a bubble where speculative fervor outweighed any economic fundamentals. He also discusses the genesis of the Case-Shiller housing price index and his idea for how it might be used to reduce risk in the mortgage market.

Note: This podcast was recorded on September 5, 2008, days before Secretary of the Treasury Paulson put Fannie Mae and Freddie Mac into conservatorship. Upcoming in the next two weeks is a podcast with Arnold Kling focusing on the role of Fannie and Freddie and the mortgage market.

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0:36Intro. Current crisis in housing market. Great Depression: We pulled together in many different ways. Spirit that we are going to solve this problem together will keep it from being worse. Capitalism is a wonderful invention, has to have a popular sense that we all support this and it's all for us. What's disturbing about the current crisis is the sense that some people are being ill-treated. Who are those folks? Complicated. Many crises in history don't make any sense. This one driven by a sequence of speculative bubbles, stock market bubble, interrupted in 2000, 2003; housing. What is a bubble? Usual definition: Unwarranted asset price boom, not related to fundamentals. Defined by the fact that it will burst. P. 2 of Irrational Exuberance, DSM definition, hard to define a mental illness so you list symptoms that are characteristic of that syndrome but not necessarily all present. Situation where there are a sequence of price rises for a speculative asset which generates a social epidemic, generates contagion, certain ideas that become prominent. New era stories, envy, trading successes become prominent in people's ideas, sense of your self changes for a while, become more self-confident because you think you've discovered your investing genius. Why does it end? It can't go on forever. Prices are rising because people expect them to rise further. Someone will want to sell. Idea of a bubble goes back hundreds of years.
6:07Role of psychology, behavioral approach. Explanations are easier ex post than ex ante. At the time there are some effects that are consistent with the price rise. How do you distinguish which ones are psychological? A matter of enlightenment. If you think about bubbles as a phenomenon you will learn earlier to recognize them. People did recognize this bubble. That's what ends them. If you think you are wiser than the herd, there is a temptation to ride the rise upward, so long as you can bail out at the right time. Part of the reason why bubbles are so inscrutable. Recent real estate bubble went on for 6 years. Not going to change over night. Can get in for a short time safely. Only those left in at the end get hurt. Transactions costs of moving in and out of the housing market are much higher than the stock market.
10:13Challenge the idea that there was a bubble. Subprime aspect: Two ways to think about the current housing market: bubble that pops, systemic effects, or that it may have had some bubbly aspects but the crisis part is in the subprime market where foreclosures play a human side to the story, securitization. Speculative boom, major historical event; multiple causes, always other factors. One other factor relevant to the recent boom, Reagan revolution, newfound respect for free markets, 1980, depository institutions deregulation and monetary control act eliminated ceilings on mortgage loans and created a possibility of a subprime industry. Before that it was a government industry because you couldn't charge a high rate. Good thing to let markets function, but there wasn't the accustomed regulation of these new lenders. As the 1990s wore on they were operating in a bubble atmosphere. At the same time, innovating, including the securitization of them. Seems like a good thing. When bad things happen in history it's difficult to point a finger of blame. Compromises. General assumption, received conventional wisdom, was that home prices can never fall; distorted into home prices are the best investment ever; everyone should get leveraged. Leverage pushed it up to a tremendous rate of profit. Infomercials at night; rang true. Idea that there could be a crash in home prices didn't sound real. Famine or another black plague. Sounded like a money machine even to rational people. Failure to think about the bubble. Appears that a lot of financial institutions were incautious, assets became risky and eventually worthless. Banks found themselves holding collateral that wasn't very good. It happens all the time in a market economy; people make mistakes, take risks they were not aware of; lose their money, lose their jobs if a firm goes bankrupt. Why is this new or a crisis? Not fundamentally new. Not associated with benefits. Economies with financial markets have more booms and busts, goes with the advantages of markets. Book: Helping financial markets work better, expanding them, not contracting them.
18:26Fed's role: did it have a role by lowering interest rates artificially, causing housing prices to go up? From 2002-2005, the real Federal Funds rate was negative, not such expansionary policy since the 1970s which had a smaller more localized housing boom. That is a part of the story. Other countries also had real estate booms where real rates were not so low, though. Even that story can be thought of as part of the same problem: they didn't see that there was any risk in the housing market. Alan Greenspan didn't see it as taking a big risk with the economy by keeping interest rates so low. Fall in housing prices is the biggest single event. High prices or low prices? When they are going up, everyone says it's great; but they forget the fact that a lot of people can now buy houses that they couldn't previously. What's the advantage of high home prices? Want to see economic growth, so you want to see incomes outpacing house prices. Alternative story, real side: Housing price run-up was largest in areas with increases in demand, Washington, D.C. area after 9/11; expansion due to Silicon area in CA. Prices reflect real side demand effects, coupled with zoning laws, etc. James Hamilton: decrease is not largest in areas with the biggest booms but in other areas, ones troubled by the subprime problem. Employment is positively correlated with home prices in a region: Michigan decline is related to the decline in the auto industry, which didn't have such a boom. Some places like Las Vegas, Phoenix, San Diego, Miami are areas with rapid price decline and were places that had big booms. Housing boom was substantially mirrored in places that have had housing bubbles before. Boom in 1920s in Florida, and CA in the 1980s. Sourdough explanation: something in the air. Markets are driven by stories. The idea that you are going to get rich in real estate isn't plausible in Milwaukee or Toledo, OH. Celebrity areas stimulate people's imaginations. Economists loosely throw around that fundamentals are driving everything. Can throw a lot of variables into a regression and make anything fit, called data mining.
27:34Zoning laws: invented in Germany, late 19th century, new idea. City would lay out a map of the city with zones; each zone would be zoned for a certain kind of construction. If you wanted to deviate you had to go before a zoning board beforehand. Before 1920s not possible in the United States, till a Supreme Court decision; no authority for a city government to intrude on people's free use of their land. Even before zoning laws there were effective requirements, like anti-nuisance laws, after a person already built. Perception that zoning laws have gotten stronger, but not entirely clear that it's true. Future of enforcement of zoning laws is ephemeral and hard to judge. Part of the new era story. Challenge is that there are so many factors involved.
30:36Data collection: Case-Shiller home price index. In late 1980s, Carl "Chip" Case rediscovered a method that had been used as early as the 1920s, improved it. Repeat sales home price indices. Most prominent index was the median home price. Problem with that is that the mix of homes changes, so sometimes a lot of homes on the west side of a town are selling and other times the east side. Volatile series. Instead, created an index that focused on the same set of homes. Astonishingly smooth over time. Incredible inefficiency of the home market. Stock market goes like a random walk; housing market goes in trends for years. Partly because of transactions costs; but also because nobody sees the data. Data went back to the 1970s, was electronic, punch cards. In 2nd edition of book, wanted to get a long historical series, so found some bits and pieces before that, from 1890 to the present. Not the last word, but it's the only one. Dirty work. One of the challenges is dealing with new home construction. Trend in U.S. has been toward dramatically larger houses. Once they are in the index it's controlled for. Macro Markets, do what people do with stock price index. It changes substantially over time, new companies start, old companies fail or merge. Wanted the indices to be tradeable, to represent the value of the housing stock, like S&P 500. Value weighted.
37:16Index allows wise people to make money and not so wise people to take risks or lose money. Why would you call this a crisis, given that most of the time the housing market has been pretty smooth? Last few years, people made mistakes. Why should we worry about this relative to any other mistakes people make in their investing behavior? What is the systemic part of it? Systemic externality that operates both through institutional and psychological channels. 2007 when magnitude became palpable, we saw securities down dramatically, domino effect. Bernanke testified when Bear Stearns went under, could cause contagion that would spread. Justified Fed action, enhanced the power of the Fed, less than disinterested spectator. How do we know that we stood on the brink of a crisis? We don't know. We do know that there have been terrible crises in history, like the Great Depression. Protections like Deposit Insurance; and like the Federal Reserve which was set up in response to 1913 crisis. What if Bernanke had said: Let's let Bear Stearns fail? Over $50 trillion; one contract offset with another. Not safe if there is a major failure with a company that is involved in so many of those contracts. Crisis when trading suddenly stops; atmosphere of pessimism develops. Plausible that Bernanke is right.
43:07Non-transparency: What we have right now is the Fed acting in an ad hoc, discretionary way. Bernanke is a scholar of the Great Depression; he certainly wouldn't want another one. Costs of avoiding such a depression are not borne by him but by all of us. Agency problems. At a time of a boom, the Fed is reluctant to say something that might squelch the boom or talk about risks lest they be blamed. Bernanke has a sense of public service. Difficult to make distinction. What would make financial markets work more effectively? 1. Improve financial information infrastructure; 2. expand the scope of markets so that more risks are traded; 3. improve retail products. Democratize finance. Take opportunity to continue the trend. Have to extend the scope of financial functioning so that it helps more and more people. Current situation is a failure to apply the basic principles of risk management well. People were encouraged to put leveraged investments into one city; undiversified use of their life savings, depending on Social Security. Mortgages that are risk managing for the homeowner: workout continuously, not only at crisis time. Mortgage payments indexed to home prices so that when home prices go down, mortgage balance and payments would go down. New standard. In 1930s, new standard, moving from 5-year rolling balloon payment mortgage to long term 15-30 years. Could have moved further forward. 2008 Housing and Recovery Act is an after-the-fact workout. Would a bank find that attractive? Futures markets for single-family home trading at Chicago Mercantile Exchange, but not very active. Mortgage issuers would be able to hedge themselves, international marketplace, spreading the risk. Same argument used for subprime market, securitization. Core idea was not the problem; it was the implementation. Financial education. Current crisis could cause a reversal of the good trends of democratization of finance. A lot of people are able to own homes.
53:16Would a bank find such an instrument to be profitable? Banks and insurance companies: home equity insurance could be offered separately. Get enthusiastic responses, but we don't have a liquid market for a home price derivative. In the U.K. there is a lot of commercial derivative trading. We may see more willingness once they see the hedging markets. Financial markets have shown progress in every decade of the last century. Taping on Sept. 5, 2008. Book is 178 pages, non-technical, accessible treatment. Fairness and bailouts: Congress designed a band-aid with the Housing and Recovery Act. What if nothing happens beyond that? No political solution, no further band-aid expansion. Signs of a weakening world economy, home price debacles elsewhere. If we don't do anything we might be in for a serious recession. Japan-style outcome: risk of a slow economy for some time going forward. Risk of social bad feeling that expresses itself with unrest in labor markets and less willingness of entrepreneurs to take risks. Bad outcome but not as bad as the Great Depression. In Japan, the lost decade. Could be increases in prime rates. Hard to predict. Interesting times for economists.

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COMMENTS (10 to date)
muirgeo writes:

Thanks for a great discussion.

I'm left, however, still not feeling very convinced we have an answer. The one thing that seems to have changed after steady and stable growth of home ownership for 30 years is a relative deregulation of the involved industries and a boom in new complex financial products. With out these "free market" changes I'm not convinced this bubble or collapse would have occurred. The free market designed these products to supposedly decrease risk when in fact these products were specifically made to be opaque as was the reason for requesting "hands off" from oversight. The market and it's experts failed miserably at its job of decreasing risk and allocating capital and of offering secure investment products to main-street America.

The solutions offered in the discourse seemed very superficial. And the concern that this issue might cause a resurgence of regulation seems paradoxical to me considering the historical facts and outcomes... I mean look at the home ownership graph I gave above.

Why can't we just go back to the good old days when banks made loans backed by the government and held primary responsibility for them and investors used their own capital to push whatever products they wanted clear of any ties to the treasury? What seems to have happened here is that the wall between banks annd investors broke down, too big to fail monopolies resulted and now had unlimited governmental credit and insurance to play with and even friendly insiders in the Fed and credit agencies to held build their pyramid scheme.

Ideas for solutions like, "Index allows wise people to make money and not so wise people to take risks or lose money." already seems complicated to me. I don't think I'm one of those wise people you are talking about who might benefit from more complicated products and more "economic democracy". Let the free market system run side by side with a government system then just let people know which is which then they will have all the knowledge they need to decide what side they want to put their money into.

Bill writes:
"The one thing that seems to have changed after steady and stable growth of home ownership for 30 years is a relative deregulation of the involved industries and a boom in new complex financial products..."

One thing that hasn't changed is a central body that creates money and pushes interest rates downward. This has to be part of the equation because without cheap credit as the hot air, the bubble doesn't expand. This is my problem with Shiller (and others) when he discusses bubbles - he just assumes that the bubble is some psychological phenomena, i.e. irrational exuberance.

We also can't ignore the incentives that were put in place by government. Many politicians and community activists encouraged the expansion of home ownership. This article in the Washington Post explains how the Fannie and Freddie mess was a product of political process.

Fannie Mae, and to a lesser extent Freddie Mac, became enmeshed in the fabric of political Washington. They were places former government officials went to get wealthy -- and to wait for new federal appointments. At Fannie Mae, chief executives had clauses written into their contracts spelling out the severance benefits they would receive if they left for a government post.
The companies also donated generously to the campaigns of favored politicians. The companies' political action committees and employees have donated $4.8 million to members of Congress since 1989, according to the Center for Responsive Politics.
In tying itself to politicians and wrapping itself in the American flag, Fannie Mae went out of its way to share credit with politicians for investments in their communities.

Jeff Henderson writes:

Shiller is obviously right that bubbles are caused by people driving up the prices in an unsustainable way based on a false picture of the market. But the origin of this false picture has to be the Fed pushing the interest rate to an artificially low level, and the government subsidizing risky mortgages through Fannie and Freddie.

Christos Kitromilides writes:

Bill is right on the spot.
Fiat money and the certainty that big Banks cannot go under will always produce the same results

Andy Kneeter writes:

Robert Shiller is missing some of the critical drivers of the housing bubble, so his solutions won't work. The 2 main drivers are large up-front compensation for most fiduciary parties that were writing long-term loans & implicit government guarantees. This set off a chain of events that fueled the bubble. Up-front compensation reduced the necessary focus on smart underwriting. Implicit government guarantees of credit performance further promoted dumb underwriting.

2 examples of this are Freddie Mac & Fannie Mae. As government sponsored enterprises (GSE), there was an implicit government guarantee of credit performance for investors in their securitized mortgage paper. This resulted in a lower cost of capital that enabled them to capture enormous market share. As GSEs, politicians put enormous pressure on them to write riskier loans to sub-prime borrowers (what did Freddie & Fannie care? Everyone was making lots of money, regardless of portfolio performance). Finally, all fiduciaries (i.e. - executives, mortgage brokers, etc...) were paid enormous up-front compensation to write mortgages & grow earnings. Layer on a clear conflict of interest, where Freddie & Fannie were paying off the politicians that were ultimately responsible for regulating them, & we've got a prescription for disaster.

The solution is simple. All investors (both debt & equity) should profit or fail on the performance of their investments. Rating agencies should take account of how much front-end & back-end compensation investment fiduciaries are getting. If those fiduciaries make lots of money on the back end, when loans are repaid, & minimal money on the front-end, when they're underwritten, they will be a lot more careful than they are now.

The best example of this is Dial Finance (now Wells Fargo Financial). Branch managers were given all underwriting responsibility & they were paid on the bottom-line profitability. Best of all, they had to personally collect their own delinquent loans. There was no centralized computerized underwriting or centralized collections. Dial's system was more costly & difficult to operate than the common centralized approach, but the strongest incentives to write secure & profitable business were in place.

Chris writes:

"Note: This podcast was recorded on September 5, 2008, days before Secretary of the Treasury Paulson put Fannie Mae and Freddie Mac into conservatorship. Upcoming in the next two weeks is a podcast with Arnold Kling focusing on the role of Fannie and Freddie and the mortgage market."

I guess it is an unfortunate restriction of logistics that we can't get a commentary on recent events. I would really look forward to insights about the state of global finance.

Russ Wood writes:

Russ,
As I posted over at the Cafe, Shiller misses a huge factor.
The housing boom is referred to as a bubble because most people, including smart economists, cannot explain its origins. "Bubble" is a catch-all for events that observers cannot explain. Somehow it calms some people to think the market is simply irrational (and it gives support to the idea markets should be regulated).
The housing boom began in 1997 after the change in the tax treatment of home sales. The impact of the new law was to make the gain on the sale of a home virtually tax free ($500k of GAIN to joint filers covers almost everyone). This amounted to a tax cut of between 20% and 40% depending on the filer. It is therefore perfectly rational for housing values to increase by that much (or more) as a result.
This boom directly impacted the higher end of the economic ladder first (since they pay the most taxes), and spread throughout the economy as folks moved up the housing ladder. It only hit a snag when those at the bottom could not get financing. At this point, GubMent stepped in, and the rest, as they say, is history.

Trevor writes:

I think that the one faux pas is that a house is referenced as an Asset. It's not, it's a liability and needs to be treated as such.

There is a glut of houses out there unoccupied so anyone with a job should be able to rent a house that is as nice as the one they lose for not being able to make the mortgage. Some will get better houses for the same or less money or even stay in the house they are in and rent from the person (or company) that gets the house in a short sale.

Peter Schiff lays a lot of this out perfectly in his book that he wrote 2 years ago.

Schepp writes:

You mention several times in recent podcast that Bernanke is a student of the great depression and he does not want to let that happen again.

Do you think Bernanke and Paulson are both command and control type of guys from their previous employment, and now they may be much better served by Hayekian approach? They just don't know it. They seem to see everything that could go wrong and don't seem to see the incentives for market particpants to look out for their self interest and make corrections on their own. Certainly Wall street would like all the government cash they can get, but that seems not to address how to get rid of all the card houses that need to fall for us to be healthy.

David Zetland writes:

Those of you interested in the real estate MARKET may want to look at one of my papers, in which I describe a Real Estate Market Index. Unlike the Case-Schiller index, which captures PRICE, the REMI captures liquidity, which happens to be important to many people now.

This link [PDF] gives updated numbers on the REMI (showing that the market in Mission Viejo, CA returned to "normal" liquidity in Aug 2008) as well as a link to the academic paper.

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