The Short View: Housing bubble By John Authers, Investment Editor
The Short View: Housing bubble By John Authers, Investment Editor
Copyright The Financial Times Limited 2007
Published: May 3 2007 17:21 | Last updated: May 3 2007 17:21
Behavioural economists have a dire prognosis for housing. Robert Shiller, the Yale economist whose book Irrational Exuberance diagnosed the internet bubble immediately before it burst, now sees similar symptoms in US housing.
Behavioural finance substitutes insights from experimental psychology for the economic assumption that people behave rationally. Account for the systematic ways we make bad decisions, and you can explain how markets lose touch with reality. Shiller’s Case-Shiller house price indices show US house prices moved in line with rents for years. Then they exploded. During the past 10 years they have increased 182 per cent, while rents barely moved. Why?
Shiller says home-buyers are prone to persistent flaws in the way they make decisions. First, there is wishful thinking. Exactly as sports fans overestimate their team’s chances of winning, homebuyers are sure their house is a winner. Gamblers prefer games in which they think they have skill: those whose house has appreciated fall into the same trap. Booms inflate their expectations.
The human brain indexes facts in terms of stories about people, not in terms of numbers. Once prices start rising, everyone knows someone who made a killing selling their house. That becomes the story.
Then there is money illusion. We remember the prices at which we bought and sold. Unlike stocks, house prices are not “split” over time. So we think in terms of huge nominal profits, and forget inflation, costs of repairs, and mortgage interest. Stocks are quoted as annual rates and compared to indices; not so houses.
Add this up and Shiller thinks Americans have formed a housing bubble to match the internet bubble. But others have it worse. Between 1997 and 2005, house prices in Ireland, the UK and Spain all rose by more than twice the increase for the US. Mad? Maybe not. Behavioural economists might simply say the Irish, British and Spanish are very bad decision-makers.
Copyright The Financial Times Limited 2007
Published: May 3 2007 17:21 | Last updated: May 3 2007 17:21
Behavioural economists have a dire prognosis for housing. Robert Shiller, the Yale economist whose book Irrational Exuberance diagnosed the internet bubble immediately before it burst, now sees similar symptoms in US housing.
Behavioural finance substitutes insights from experimental psychology for the economic assumption that people behave rationally. Account for the systematic ways we make bad decisions, and you can explain how markets lose touch with reality. Shiller’s Case-Shiller house price indices show US house prices moved in line with rents for years. Then they exploded. During the past 10 years they have increased 182 per cent, while rents barely moved. Why?
Shiller says home-buyers are prone to persistent flaws in the way they make decisions. First, there is wishful thinking. Exactly as sports fans overestimate their team’s chances of winning, homebuyers are sure their house is a winner. Gamblers prefer games in which they think they have skill: those whose house has appreciated fall into the same trap. Booms inflate their expectations.
The human brain indexes facts in terms of stories about people, not in terms of numbers. Once prices start rising, everyone knows someone who made a killing selling their house. That becomes the story.
Then there is money illusion. We remember the prices at which we bought and sold. Unlike stocks, house prices are not “split” over time. So we think in terms of huge nominal profits, and forget inflation, costs of repairs, and mortgage interest. Stocks are quoted as annual rates and compared to indices; not so houses.
Add this up and Shiller thinks Americans have formed a housing bubble to match the internet bubble. But others have it worse. Between 1997 and 2005, house prices in Ireland, the UK and Spain all rose by more than twice the increase for the US. Mad? Maybe not. Behavioural economists might simply say the Irish, British and Spanish are very bad decision-makers.
posted by Carlos T Mock at 8:49 AM
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