Robert Shiller says Fed and other Central Banks do not have remedies like lithium or Prozac to counter the reversal of the Psychology that fed property booms
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| Robert J. Shiller is the Stanley B. Resor Professor of Economics, Department of Economics and Cowles Foundation for Research in Economics, Yale University |
On Wednesday, a day after the US Federal Reserve triggered a global stocks rally with its surprise half percentage point cut in the Federal funds rate to 4.75%, Yale University economics professor Robert Shiller, whose book Irrational Exuberance, predicted the end of the high-tech stock bubble, warned that the housing crisis may well trigger a recession despite interest rate cuts.
"I am worried that the collapse of home prices might turn out to be the most severe since the Great Depression," Shiller, a longtime analyst of real estate, said in testimony before a Congressional committee.
Shiller, who designed the respected Case-Shiller House Price Index (see Q2 2007 Index), with fellow academic Karl Case, said the current market problems, the most recent of which are the excesses and explosions in mortgage lending, have their roots in a wildly overvalued housing market.
"The US housing market gained 86% in real inflation-corrected value from 1998 to the peak in early 2006. In my view, this degree of asset value inflation was unwarranted, and driven by excessive investor enthusiasm for housing as an investment. Since the peak, it has lost 6.5% of its real value," Shiller said. "Note from Figure 1 (see below) that neither the rise of home prices to 2006 nor the fall thereafter can be attributed to changes in the rental market for homes or to changes in building costs. That is part of the reason why I believe that the home price changes are basically speculative, and, I believe, driven by market psychology."
Professor Shiiler made the observation that price appreciation in housing markets since 1998 has been more concentrated among low-priced homes than high-priced homes. "This fact is consistent with our observation that the growth of subprime loans has been an important driver of home prices," he said.
Shiller said that declines in residential investment have been an important factor in virtually all recessions since 1950. "The last time we saw such declines, in 1990-91, there was a U.S. and worldwide recession, of rather short duration, but followed by a weak economy for several years. The housing boom since the late 1990s was clearly bigger than the one that preceded the 1990-91 recession, and the contraction in residential investment since last year is sharper," he said. "I am worried that the collapse of home prices might turn out to be the most severe since the Great Depression. It is difficult to predict the depth, duration and all of the consequences of such a decline operating in a much more complex modern economy. My own research, with Karl Case and John Quigley, has shown a strong effect of housing prices on people’s spending historically, which would suggest that consumption spending would contract as home prices fall. But, even beyond the effects that we have found in past cycles, the bursting of the housing euphoria, and the attendant financial crises, may bring on a further loss of consumer confidence, given the size of the price drops and media attention the current crisis has been generating."
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| Figure 1 |
Shiller said that there is a significant risk of a recession within the next year. "The Federal Reserve will undoubtedly take aggressive actions, which will mitigate its severity. But, if home price deflation persists or intensifies, they may discover that the Achille’s Heel of this resilient economy is the evaporation of confidence that can accompany the end of boom psychology," he said.
In concluding his testimony, Shiller said that he has been a strong advocate for financial innovation. Financial innovation has the potential to reduce economic risks and promote economic growth. But at the same time, he says that he has argued for many years that despite financial innovations, what Alan Greenspan termed “irrational exuberance,” that is irrational optimism about investments and economic prospects, can substantially disrupt financial markets from time to time.
Last month, in an article in The New York Times, Shiller said that the Fed can stop a run on the banks, but it cannot control the speculative cycle — a cycle built on psychology and misperceptions that has been sweeping much of the world for the last 10 or 12 years.
Shiller wrote:
I have worked with Karl E. Case, a professor of economics at Wellesley College, with help from the Yale School of Management, in conducting questionnaire surveys of recent home buyers. In Los Angeles and San Francisco in 2005, when actual home prices were rising more than 20 percent a year, we found that respondents anticipated big increases far into the future. At that time, the median expected annual climb for the succeeding 10 years was 9 percent.
This expectation would mean that a house valued at an already high level of $650,000 in 2005 would be worth more than $1.5 million in 2015. For most people in 2005, it would also mean that they should buy a house soon, or forever be excluded from owning one — and that it would be better to stretch and buy the most expensive house they could afford, to capture the huge profits of homeownership.
Now, of course, prices have been falling, and our survey over the last few months shows that in Los Angeles and San Francisco, the median 10-year expected price increase among recent home buyers has come down to 5 percent a year — a number that is likely to decline further if prices continue to drop. As price expectations fall, homeowners lose the incentive to pay off a mortgage on a home they are realizing is beyond their means. They decide to default. We thus have the beginnings of a mortgage crisis.
Shiller says now the problem is fundamental, tied to the imbalance caused by irrationally high home prices and declining optimism that the prices will go higher. Cutting interest rates will not change this basic situation.
Noting that housing booms have been commonplace since the late 1990s in North America, Europe, Asia and Australia, similar worldwide boom cycles in the stock market over the last 10 or 12 years have been experienced while just about every major stock market around the world has boomed since 2003.
Shiller notes that while the IMF's real per capita growth figures for gross domestic product worldwide have been fairly high since 2004: at around 4% a year, they compare with only 2.4% in the period 1995 to 2003, when the booms took hold. He warns against overstating the importance of both China’s and India’s economies in the current global growth cycle, saying that they only account for "a tiny fraction" of world G.D.P.— together only 7%.
Shiller argues that the growth of capitalism around the world has caused trust in the social safety net to decline. He says that people worry that they must increase their wealth to fend for themselves. So rather than becoming smart savers the choice has been to become smart investors.
"Many people feel that they have discovered their true inner genius as investors and have relished the new self-expression and excitement. Investors across the world have been thinking that they are winners — not recognizing that much of their success is only a result of a boom. Declines in asset prices endanger this very self-esteem," Professor Shiller wrote. "That is why it is so hard to turn around investor attitudes once a downward psychology sets in. The Fed and other central banks do not have lithium or Prozac in their bag of remedies, and so cannot control it."
