The recipe for housing bubbles
Economist Robert Shiller, writing in Sunday's New York Times, attempts a logical explanation for housing bubbles -- not just why housing prices sometimes rise faster than housing values, but why sensible people such as federal financial regulators can watch this happen without noticing a problem.
Shiller is perhaps the nation's foremost expert on housing prices, and he is a loud proponent of the idea that housing prices rose to their peak in 2005 because of "irrational exuberance" -- in other words, people paid more than they could reasonably expect the next person to pay for the same home.
It's worth pausing on this point for just a second. There is an intuitive argument that a successful sale is the best possible way to value of an object. If the home sold for $200,000, obviously it was worth $200,000. But economists such as Shiller, value means something different: The price you should pay.
Shiller writes that bubbles form because people make decisions based on incomplete information. Some people will make the "wrong" decision. The result is the crucial point: Those incorrect decisions then become pieces "true" information that influence other people's decisions.
Let's say a house is worth $200,000. The available data is incomplete and blurry. Most of it shows the house is worth $200,000. Some shows the house is worth $225,000. One person decides -- incorrectly -- to pay $225,000. There is now one more piece of evidence the house is worth $225,000.
Shiller cites research showing that a group of people operating with information that is 60 percent accurate will tilt toward bad choices 37 percent of the time.
And the same is true for regulators watching the market and trying to decide whether to intervene. They, too, are influenced by people's bad decisions. They are more likely to perceive those decisions as accurate.
(I would just add that this model helps to underscore the damage caused by mortgage fraud, where people are intentionally paying more than a home is worth. These acts tilt the scale toward bad decisions because some people aren't trying to weigh the evidence -- they are intentionally making wrong choices.)
The cartoon comes from the Irvine Housing Blog.
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All Shiller is really saying in the Times article is that (contrary to the premise of the efficient market theory) large numbers of people sometimes act like lemmings for extended periods of time. The stock market bubble of the late 90's as well as the more recent housing bubble provide more than ample evidence that the masses are capable of inflating irrational bubbles.
I disagree, however, with Shiller's notion that highly educated people like Alan Greenspan were just innocently caught up in this. I think the "leaders" who allowed the housing bubble to happen are just trying to protect their legacy by entering a plea of "how could I have possibly known". If it really never occurred to Greenspan that a bubble and crash of this magnitude could happen, then a PhD in Economics must not be worth very much.